Piqued by Piketty

June 10, 2014

The rise of the middle class has been a hugely important political and social development across the world, spanning a large part of the 20th century. How would society change if the number of jobs that have historically driven this section of the population were to come crashing down, as a result of technological progress and automation? Would widespread unemployment potentially result in the kind of social, political and economic unrest normally associated with wars? More importantly, would the economic inequality brought about by such changes cause civilization to go off track?

Thomas Piketty, an economist at the Paris School of Economics, recently published a book in which he argues that the US might be pioneering a hyper unequal economic model in which the wealthy top 1% hold the lion’s share of the national income, leading to an ever increasing marginalization of the middle class. The book has had some glowing reviews, with one reviewer terming it “An economic, social and political history of the evolution of income and wealth”. Piketty’s inspiration is wide ranging, taking cues from the books of Honore De Balzac and Jane Austen, and offers a treasure trove of data that he along with his Berkeley collaborator Emmanuel Saez have collected over the last decade. As the world bank researcher Branko Milanovic says in his review,

“I am hesitant to call Thomas Piketty’s new book Capital in the 21st century (Le capital au XXI siècle in the French original) one of the best books in economics written in the past several decades. Not that I do not believe it is, but I am careful because of the inflation of positive book reviews and because contemporaries are often poor judges of what may ultimately prove to be influential. With these two caveats, let me state that we are in the presence of one of the watershed books in economic thinking.”

Heady praise indeed.

Piketty’s main thesis is that over time, the return on investment will be higher than the rate of growth of the overall economy, implying that extremely wealthy individuals will own a bigger slice of the global economic pie. In fact, he believes that this will happen automatically without any natural factors to staunch its progress. Technology and automation will serve merely to enhance this process, given a large section of society will lose their jobs and the resulting mass unemployment is likely to create a society rife with social unrest and upheavals, further weakening the middle class.

If these arguments have wings, then it becomes entirely clear that there are world altering factors at play here. A future which holds widespread unemployment, even though technological progress has historically never failed to generate new opportunities, is hard for most to accept and plan for.

Inequality has been a matter of routine for most portions of human history. A large fraction of the super rich have been born into wealth, and it has only been in recent times that the common man has been able to achieve parity with them through their own efforts. Since the post World War II period began, it has seemed but obvious that the reduction in inequality in various countries around the world has been a direct result of the political environment surrounding democracy and the policies that stem from it. But if one listens to Piketty, democratic and capitalistic principles don’t automatically lead to a reduction in inequality – this period was in fact an aberration rather than being the norm.

Like many other unifying theories, the development of a unified theory for capitalism has been the holy grail for a large number of economists in the past century or two. Rev. Thomas Malthus laid down the theory that the growth in population would keep the bulk of humanity trapped in poverty – and this was most definitely the case for most of human history. David Ricardo linked the value of a fixed amount of land relative to the expanding supply of other goods to the wealth of the landed aristocrats. And finally, Marx predicted that competition amongst workers and investors would drive down wages to levels that would offer bare sustenance, concentrating wealth in fewer hands.

What all of them failed to anticipate and account for was the fact that there was an explosion of productivity driven by new technology, which allowed the masses to insure themselves from the dystopic futures that had been imagined for them. This “fact” has become commonplace enough in today’s economic scenarios that no one has really debated its veracity.

Enter Piketty. With an impressive collection of data going back centuries to back his theory up, he argues that that the underlying mechanisms of capitalism are likely to reassert themselves, once again generating “arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based.”

There are two ways of thinking through this – the first is to determine how governments would deal with a situation like this, if it were to arise. Would a significant percentage of the population need to be supported by a welfare state? Can one then say that democratic states that adhere to a capitalistic model are actually driving themselves to a state of socialism? Mass unemployment is bound to cause social unrest at scale – what are governments to do then? Entirely new models of dealing with this would be needed. Are people thinking about this before it’s too late?

The second is about how we can check and overturn the events that are leading us down this path. Can we prevent the accumulation of wealth in the hands of a few, and prevent a class of rentiers – the small group of wealthy yet untalented offspring of the current generation which controls vast sections of the economy and strikes down competition from the talented but poor have-nots? In essence, are we saying that our economic future in a few generations will look like Europe before the First World War unless something is done about it?

Perhaps we are. So what should we do about it?

Piketty proposes is the introduction of a global progressive tax on individual net worth. Those who are just getting started in their careers would pay little, but those who have billions would pay a lot. This would not only make it easier for people to climb the ladder, but it would also inject transparency into the processes that drive global wealth dynamics by putting them under public scrutiny – as he mentions, “The lack of financial transparency and reliable wealth statistics is one of the main challenges for modern democracies”.

Sounds good on paper, but there’s more to it from a practical standpoint than meets the eye. As Tim Worstall in his excellent Forbes article points out, there is a real world barrier to how much tax can be extracted from the super rich, in the same way sales tax rates are bound by real world constraints.

Sales tax is levied at the point of retail such that the ultimate seller of the product can pay a regulatory authority a portion of the sale price. If we wanted to increase the sales tax on a given product, it couldn’t be done purely at the point of sale itself – we would have to levy it at every step it takes to manufacture that product so that every participant can recover the tax they’ve paid. This allows us to charge a pretty high tax rate (which is termed Value Added Tax or VAT) without seeing issues like tax evasion eat into the collected amounts.

An issue not unlike the one described above tends to occur when we try to levy higher wealth taxes. Countries like France do levy wealth tax at arond 1-2%, but they’re able to do this only because the rate of return on capital is much higher than the tax rate, and the super rich are able to pay this out of their income, while maintaining their wealth.

What Piketty proposes is a tax that is much higher – so much so that it eats into the wealth itself. It’s almost like taking from the rich and giving it to the poor, except in a regulated and legal way. Robin Hood would be proud. And this is where we run into a vexing problem.

If a higher tax like this was imposed, it would mean that the super rich would need to give away money from their holdings to pay it. Assuming we were to set this tax at 10%, someone like Bill Gates or Warren Buffett would have to pay out around $7-8 billion per year in taxes, meaning they would have to liquidate their wealth (which in most cases today tends to be locked into stocks, securities and other investments such as art or jewelry). The question now is – who buys this from them in return for cash? Stocks and financial instruments are relatively easy – there are enough organizations such as mutual funds that are willing to offer hard cash for them. But how do they sell immovable assets like property (after all, one can’t just sell 10% of a mansion), or priceless pieces of art? In trying to do this, we’re reducing the value of the items that are being sold, which in turn reduces the wealth of those who hold them.

Piketty’s book doesn’t hold answers to this question – but it is definitely different from the others in that it offers not just a set of guidelines to policy makers on potential solutions to stem the rate at which inequality is increasing, but also makes a call to people on the street to “take a serious interest in money, its measurement, the facts surrounding it and its history”. As he mentioned to an interviewer,

“It’s too easy for ordinary people to just say, ‘I don’t know anything about economics, but economics is not just for economists”.

Agreed. Even if his proposals don’t end up being actionable very soon in any real manner, he has started a public debate that I hope will have very real repercussions in the way we think about income inequality and ways to address it today and in the future.